The individuals and institutions that invest in hedge funds are surprisingly different

Types of Hedge Fund Investors

The individuals and institutions that invest in hedge funds are surprisingly different in terms of risk tolerance, investment horizon, investment objectives, and investment restrictions. Many of the differences between investors involve the way they are taxed (if they are taxed at all). This chapter includes a discussion of the tax treatment of these investor types. (Hedge funds usually pay little or no tax but must flow through the taxable amounts to investors in many countries, including the United States. For a description of how a partnership calculates the tax consequences of the hedge fund investments)

INDIVIDUAL INVESTORS

In the United States, individuals provide more money to hedge funds than does any other group. They were prominent among early hedge fund investors. They have always been an important group to understand for marketing, investment policy, tax reporting, and public policy.

On first impression, one would think that the motives of individual investors should be easy to understand because they should have the same concerns about returns, risk, and taxes. In fact, investors interests may differ markedly.

Individuals are likely to invest directly in single-manager hedge funds. Other types of investors are much more likely to invest in funds of hedge funds (see Chapter 2 for a description of funds of funds). Recently, however, individuals have begun placing much of their new money into funds of hedge funds.

High -Net -Worth Individuals

Most individuals who invest in hedge funds are affluent and are taxed at high marginal rates. High-net-worth individuals have a disproportionate portion of the investment assets simply because of their high net worth. Federal securities laws also severely restrict middle-income and lowincome investors from investing in hedge funds (see Chapter 8), so highnet-worth individuals contribute most of the investment dollars from individuals.

Security regulations define a high-net-worth individual in a variety of ways. An individual who is an accredited investor has income of at least $200,000 or assets of $1 million (see Chapter 8 for greater detail about securities regulations related to accredited investors and other topics discussed in this chapter). Other regulations draw the line at $2 million for a qualified eligible participant (QEP). Finally, a qualified purchaser is an individual investor with a net worth exceeding $5 million.1

Regardless of how these break points are defined, the typical investor has a high marginal tax rate. Yet the typical hedge fund produces most of its return as short-term capital gains or ordinary income, both of which are taxed at high marginal tax rates. In contrast, other investments are taxed more favorably. Municipal bonds are not taxed at the federal level and may be exempt from state and local income tax. Other investments, such as common stocks, provide a large part of their return in the form of capital gains that may be taxed at a lower rate for long-term gains. The tax may be postponed indefinitely (if the investment is held indefinitely), or may even escape income taxation if held until death.

Suppose an individual paid individual income tax at the 37 percent rate for ordinary income and short-term gains and paid 18 percent on long-term gains.2 Suppose further that capital gains can be postponed on

stock investments for five years. The after-tax return on the stock portfolio, assuming a pretax annual return of 10 percent and a short-term discount rate of 5 percent, is given by equation (3.1).

In other words, in this scenario, a high-net-worth individual must earn 34 percent higher pretax return than stocks to do as well after taxes.

High-net-worth individuals may invest in hedge funds because they expect a sufficiently higher return to accept the tax disadvantage of the investment vehicle. These individuals may believe that hedge fund returns are less volatile than stock returns to justify the tax-disadvantaged investment. Finally, the hedge fund may provide a low correlation of return to other assets in the portfolio so a small investment in hedge funds (say 10 percent to 20 percent) may lower the volatility of the portfolio enough to justify making a hedge fund investment.

The answer to question 2.13 in Chapter 2 presents a formula for the average return on a portfolio. That formula with an extension account for taxes is shown in equation (3.3). Assume that the pretax expected return is 10 percent for both a traditional stock position and a hedge fund. Assume also that the investor pays ordinary income tax at 37 percent and longterm capital gains are taxed at 18 percent. Suppose that 100 percent of the stock return is taxable as long-term capital gain and 100 percent of the hedge fund return is taxed as ordinary income. For simplicity, assume that the stock strategy does not defer the taxable gain at all. Equation (3.3) shows the after-tax return for an individual with a stock portfolio comprising 90 percent of the investment assets and a hedge fund with the remaining 10 percent of the assets.

In this scenario, the hedge fund return lowers the aggregate after-tax return because the higher tax rate on the hedge funds pretax return lowers the after-tax return below the stock after-tax return.

Assume that the stocks and the hedge fund in the preceding example have standard deviation of return (also called volatility) of 20 percent annualized. However, the returns have a correlation of only 25 percent. Relying on the formula for portfolio volatility presented in answer 2.13, the standard deviation of return on the portfolio is given by equation (3.4):

The hedge fund provides a lower after-tax return but also a lower level of volatility in the combined portfolio. Clearly, if the individual investor can locate a hedge fund with returns higher than the investment alternatives, this comparison looks more favorable still.

It is also clear that individual investors would prefer hedge funds that: (1) have higher expected return; (2) have lower volatility; and (3) have lower correlation to assets already in the portfolio. Similarly, if a hedge fund could deliver some portion of its return as long-term capital gain, it could create higher after-tax portfolio returns than hedge funds that provide a return taxed as ordinary income.

Semiaffluent Investors

There is currently much attention directed at those investors who marginally qualify to invest in private hedge funds or would not qualify to invest in a hedge fund sold as a private placement but could invest if the fund was registered (see Chapter 7). This group is sometimes called semiaffluent or nearly affluent.

Writers define this group differently. Some categorize individuals with a net worth of between $1 million and $10 million as semiaffluent.3 Others include investors with between $500,000 and $1 million in this group.4 J. P. Morgan also includes investors above $1 million in a group called semiaffluent.5 Regardless of how this group is defined, it includes

investors who historically have not had access to hedge funds. Due to changing attitudes, changes in the risk profile of the hedge funds, and new legal developments (notably the registered fund of fund), this group represents a large, almost untapped market.

The appeal of marketing to this group of investors is: (1) it constitutes many investors; (2) despite the more limited resources of individual investors, it constitutes a large potential pool of funds (by one account, semiaffluent investors control between $6 trillion and $8 trillion in assets6); and

(3) this group has invested little in hedge funds to date.

The semiaffluent investors want to invest in hedge funds for the same reasons that high-net-worth investors invest in hedge funds. Because many hedge funds are less volatile than a broadly diversified portfolio of common stocks, these investors may invest in hedge funds to lower the risk of their portfolios. With similar objectives, these investors may seek to lower the volatility of their investment portfolios by diversifying into hedge funds with low correlation to stock and bond returns. Finally, some semiaffluent investors seek out hedge funds to increase the return on their investment assets.

As with any group, there are great differences between individuals who could be considered semiaffluent. At the risk of ignoring these differences, it is still possible to distinguish this group from the high-net-worth investors in hedge funds. First, the semiaffluent investors are less likely to have ready access to professional investment and legal advice. Second, the semiaffluent investors are less likely to feel comfortable investing in highrisk/high-reward strategies. Third, the semiaffluent investors are more likely to invest in hedge funds indirectly, by investing in funds of hedge funds that permit smaller minimum investments than single-manager hedge fund minimum investments. Sometimes these funds of funds have been registered and accept investments as low as $25,000.

Considering the many benefits hedge funds offer to investors, it is reasonable to encourage the semiaffluent investors to move into hedge funds. Securities law and practices often prevent hedge funds from accepting investments from this group. The Securities and Exchange Commission and the Commodity Futures Trading Commission appear to be interested in improving access to hedge funds by the semiaffluent.

Individuals may invest money held in retirement accounts in hedge funds. The owner of the retirement account must meet the same net worth and income requirements that investors who invest in hedge funds outside a retirement account must match. The retirement account does not need to be large enough to satisfy the net worth requirements for accredited investor, qualified eligible participant, or qualified purchaser (see Chapter 8) as long as the assets of the individual (both in and out of retirement accounts) are sufficient.

The mechanisms for investing in hedge funds differ slightly, depending on the type of retirement plan in question. For example, individual retirement account (IRA) money must be held in a self-directed account (basically a brokerage account designed for IRA investing) and must find an institution willing to act as trustee for the account. A corporation administering a 401(k) plan may make a hedge fund option available to plan participants. In each of these cases, the individual makes the decision to invest in a hedge fund.

Hedge funds produce a large portion of return in the form of ordinary income. Most hedge fund investors pay high marginal tax rates because private placement laws severely limit access to hedge funds unless the investor has both a high income and substantial assets (see Chapter 8 for a more complete discussion of the income and asset requirements typically imposed on hedge fund investors).

This shows the benefit of postponing tax payments on hedge fund returns. If a taxpayer pays 37 percent marginal income tax, a $100 return would require a tax payment of $37 in the current tax year. In the table, the after-tax income is reinvested in the hedge fund, earning 10 percent but paying tax at 37 percent each year. The income with the reinvested return grows to $85.51 over five years after all taxes have been paid.

Alternatively, suppose that the tax on the $100 of income is postponed one or more years because it resides in a tax-deferred account, such as an IRA. The table shows the value of $100 of taxable income growing annually at 10 percent, as previously. If the money is withdrawn after one year,7 the investor must pay $40.70 in income tax (37 percent of $110) but would have $69.30 available after paying income taxes. The value of the deferral rises each year, so that by the fifth year, the $100 of taxable income could represent $101.46 in funds to the hedge fund investor if reinvested in an IRA but only $85.51 without the benefit of deferral. The value of deferral on this $100 of hedge fund income continues to rise each year the investment is held in a tax-deferred retirement account. In addition, the hedge fund produces additional income each year that also benefits from this deferral.

Traditional IRA The traditional or contributory IRA is the best known of a growing list of tax-deferred retirement savings accounts. Contributions to the fund are subtracted from taxable income. For example, suppose an investor made a $3,000 contribution to an IRA in 2003 (the maximum permitted for taxpayers with income of $95,000 or lessthe permitted investment scales down to $0 for incomes above $110,000). If the investor pays a 28 percent tax (the marginal tax rate for a single taxpayer in 2003 for incomes between $68,800 and $143,5008), the tax liability is lower by $1,050 ($3,000 35) so the net cash flow is $1,950 to establish a $3,000

balance in the IRA. Any money (either the original principal or return on the investment) withdrawn from the IRA is taxed as ordinary income.

However, the taxpayer can defer the withdrawal for years or even decades. The deferral means that both the principal and taxes on the investment return can remain invested to earn additional return for the taxpayer.

If an investor made annual investments in a traditional IRA every year and the IRA earned a high rate of return, the IRA balance could grow to a size large enough to match a hedge fund minimum. For example, if an investor saved $1,500 in 1979, rising to $3,000 in 2003 (at the beginning of each year) and the IRA earned the same return as the Standard & Poors 500 index, the IRA would be worth about $250,000 at the beginning of 2004. This would constitute a small hedge fund investment, but many hedge funds accept smaller IRA contributions from individuals.

Several other provisions conspire to limit the number of investors with $250,000 in an IRA. First, the investor must have had taxable income in each of the prior 25 years to be eligible to make contributions. Second, although the IRA laws changed, in most years the hedge fund investor could make no pretax contributions when taxable income exceeded a threshold ($110,000 in 2003 as noted earlier) or if the investor was eligible to participate in a company pension plan. Finally, unless the IRA was invested in a portfolio earning high returns, the IRA would remain small.

Rollover IRA A rollover IRA is an IRA that has been funded by transfer from another kind of retirement account. Most rollover IRA accounts are created when an employee leaves a company with a 401(k) plan (discussed shortly) and rolls the assets into this type of IRA. Other retirement plans, such as the simplified employee pension (SEP-IRA), may also be rolled into a rollover IRA. Contribution limits are considerably higher for these retirement plans, so rollover IRAs may be substantially larger than traditional IRA plans.

Keogh Plan A Keogh plan is a self-directed retirement plan for employees of small businesses. The plan closely resembles a traditional IRA. Contribution limits are higher than the allowable contributions to an IRA (up to 25 percent of income with a dollar maximum of $30,000). Due to the higher contribution limits and because Keogh plans have been permitted for many years, investors are more likely to have sizable balances in Keogh plans than in traditional IRAs.

Simplified Employee Pension (SEP -IRA ) A SEP-IRA is another self-directed retirement plan primarily for self-employed workers. Like the Keogh plan, investors can contribute up to 25 percent of income (including salary and bonus) up to $40,000. However, to be eligible to make a contribution to a SEP-IRA in a particular year, income must be less than $200,000. Because of the higher contribution limits (more than 10 times larger than the maximum IRA contribution), SEP-IRA plans are more likely to have sizable balances than traditional IRAs even though SEP-IRAs were created more recently, in 1998.

401 (k ) Plans A 401 (k) plan is a voluntary defined contribution plan. Workers set aside part of their salaries to invest in a tax-deferred fund. Often, employers match or partially match contributions to employee 401(k) plans. Contributions are limited to 12.5 percent of income, capped at $12,000. Because 401(k) plans have been in existence for many years and have become very common, many workers have 401(k) balances that are high enough to invest in hedge funds, especially if the participating hedge fund or funds reduces the required minimum investment.

A small number of companies have begun to offer hedge fund alternatives in their 401(k) plans. Goldman Sachs and Mesirow Financial (two broker-dealers that are actively involved in the hedge fund business) offer one or more hedge fund choices in their company plans. CS First Boston allowed employees to invest in the Campbell Fund (probably more accurately described as a commodity pool) and enjoy hedge fund type returns beginning 25 years ago.

Roth IRA The Roth IRA differs significantly from the plans described earlier. Contributions to a Roth IRA do not reduce taxable income, so the Roth IRA does not enjoy the benefit of investment return on a deferred tax liability on earned income. However, investors pay no tax on either principal or investment return withdrawn from a Roth IRA. Because hedge fund returns are mostly taxed as ordinary income, it makes sense to place hedge fund assets in a Roth IRA and to hold common stocks in an ordinary investment account, to get the benefit of reduced tax rates and deferred tax liability on long-term capital gains on the stock.

Several provisions limit the ability of hedge fund investors to accumulate significant assets in a Roth IRA. First, income tests prevent highincome individuals from funding Roth IRAs. Second, similar limits restrict investors from rolling traditional IRA assets into a Roth IRA. Finally, even when an IRA or a rollover IRA can be rolled into a Roth IRA, such a rollover requires the investor to report the rolled amount as taxable income. The acceleration of tax liability on a rollover reduces the value of the tax savings compared to a traditional or rollover IRA.

Educational Savings Plans Both the so-called 529 plans and Coverdell Educational Savings Accounts (ESAs) are tax-advantaged saving plans, offering tax deferral and, in many cases, the chance to avoid tax on investment returns. Like the Roth IRA, these plans would significantly improve the return hedge fund investors keep by deferring and hopefully avoiding the tax on ordinary income that dominates hedge fund returns. Unfortunately, phaseout provisions limit the ability of high-net-worth investors to fund these plans. Perhaps as the hedge fund marketplace becomes more efficient in investing smaller amounts from the semiaffluent population, investors will begin to invest educational savings accounts in hedge funds.

Retirement Savings Plans (RSPs ) Canadian employees have a selfdirected retirement plan much like the traditional IRA in the United States. Two provisions have slowed the movement into hedge funds. First, no more than 20 percent of a fund may be invested in foreign assets. Unfortunately, Canadians have access to more U.S. or offshore hedge funds than Canadian hedge funds. Second, RSPs are severely restricted in their ability to invest in private (unregistered) investments. Although this would appear to make hedge fund investing impossible in RSP accounts, hedge funds are beginning to take money from RSP accounts. First a Canadian vehicle is created (for example, a fund of funds) to make the investments in Canadian and offshore funds. Second, the fund sponsors register the fund.